GM Cuts a Deal, but Is It Really Good for Investors?

By Markets Fool.com

Strong new products like this GMC Yukon Denali have boosted GM's profitability. Now, under pressure, GM is stepping up its plans to return more of those profits to shareholders. Source: General Motors.

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General Motors said Monday it had come to agreement with a group of activist shareholders seeking to force the automaker to conduct a big share buyback.

Under the agreement with the group led by Harry Wilson, a former member of President Barack Obama's auto industry task force, GM will "immediately" begin a $5 billion share repurchase program that is to be completed by the end of 2016. The company also agreed to other changes to return more cash to shareholders over time.

The group had sought an $8 billion share buyback program.

This represents a big change of course for GM, which has been very conservative with its cash hoard since emerging from bankruptcy in 2009. What happened here, and is it a good thing for GM and its long-term investors?

GM shareholders were skeptical, but its CEO apparently was less so
Wilson's bid came to light about a month ago, after he nominated himself as a candidate for GM's board of directors -- with the backing of a group of hedge funds that together owned a little over 2% of the company's common stock. Had he been elected, Wilson planned to pressure GM to spend $8 billion buying back its own shares.

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At the time, I said this looked like a "raid" to force GM to use its substantial cash holdings to create a spike in its share price, allowing the hedge funds to dump their positions at a fat profit. It certainly didn't seem like a good way to genuinely enhance shareholder value.

Legendary value investor Warren Buffett saw it pretty much the same way. Buffett, whose Berkshire Hathawayholds a 2.6% stake in GM, said last week he opposed Wilson's plan.

"It's just not the way to run a business," Buffett said, while expressing strong support for GM CEO Mary Barra and her senior team.

But clearly Barra herself saw some merit in Wilson's proposal.

A change in GM's approach to capital allocation
Under the deal announced on Monday, Wilson will withdraw his nomination to stand for election to GM's board, along with his group's buyback proposal.

In exchange, and after what Wilson characterized as "a constructive dialogue between our investor group, senior management, and the Board," GM will implement what it called a "disciplined capital allocation framework."

That "framework" includes "three core principles," according to GM:

  • A higher return on capital invested in GM's business. General Motors said it will "reinvest in its business with the objective of driving 20 percent or higher return on invested capital (ROIC) through investments in world-class vehicles and leading technology." Last year, GM adopted an executive compensation program that uses ROIC as a key metric, it said. It will begin reporting its ROIC performance quarterly, starting with its first-quarter earnings report.
  • An investment-grade balance sheet. For several years now, GM's leaders have talked about a commitment to a "fortress balance sheet" that keeps debt under control and holds a substantial cash reserve. Monday's statement seemed to back away from that idea a bit, referring instead to an "investment-grade balance sheet" that includes a target cash balance of $20 billion. The automaker had $25.2 billion in cash as of the end of 2014, along with $12 billion more in available revolving credit lines. Wilson has said repeatedly GM is holding more cash than necessary to sustain investment during a severe economic downturn.
  • Returning cash to shareholders. "Beyond reinvesting in the business and maintaining an investment grade balance sheet," GM said in its statement on Monday, "the company expects to return all available free cash flow to shareholders." General Motors will adopt an annual capital return plan at the beginning of each year, starting in 2016. Meanwhile, GM reiterated its plan to boost its quarterly dividend to $0.36 a share starting in the second quarter of 2015.

It sounds great if you're a GM shareholder (full disclosure: I am). But is it really great?

Is this the right thing for GM's long-term success?
It's hard to evaluate something like this right way, although that didn't stop a lot of people from trying on Monday.

The stock opened up more than 2% despite some initial concerns. Credit rating agency Moody's opined that the deal was a "credit negative," though it did not change GM's rating; but rival Fitch thinks GM's liquidity will be "adequate" under the plan and does not expect it to affect its rating of the automaker's creditworthiness.

I see two big concerns here: Will GM continue to invest aggressively in its business, and will $20 billion be a sufficiently large cash reserve in the event of a big economic storm?

I think the first one is a no-brainer: GM has said it expects to invest $9 billion in new products and facilities this year, roughly comparable to the spending anticipated from its key rivals. It does not appear GM has any intention of skimping on investment in order to send more money to shareholders anytime soon, though we will watch this in the months and years to come.

It's a little harder to answer the second question. General Motors ran out of cash and crashed into bankruptcy court in early 2009, and the point of the "fortress balance sheet" approach was to institutionalize the lessons learned from that experience so that it never happened again.

Obviously, $25 billion is a better nest egg than $20 billion. But $20 billion is still enough to fund GM's level of investment for a little over two years at current rates. As long as GM maintains access to credit at investment-grade rates, that should be sufficient -- but we'll see.

The article GM Cuts a Deal, but Is It Really Good for Investors? originally appeared on Fool.com.

John Rosevear owns shares of General Motors. The Motley Fool recommends General Motors. The Motley Fool recommends and owns shares of Berkshire Hathaway.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.